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Analysing and valuing a company

How do you read an annual report, and put your own number on the business?

22 of 22 chapters published

Chapters

Beginner

  1. What analysis is forNot to predict the share price. To work out what a business earns, how reliably, and what it would be worth if you owned all of it — so that when the price says something different you know which of you is wrong.
  2. Where the numbers come fromAudited annual results within sixty days, quarterly results within forty-five, and an annual report with the commentary around them. All free, all filed by obligation, and almost none of it read by the people who own the shares.
  3. The three statementsA period of trading, a photograph of one day, and a record of cash. They are three views of the same business and they lock together — which is why reading one without the others is how people get fooled.
  4. The income statementRevenue at the top, profit at the bottom, and a dozen lines in between that say where the money went. Each line answers a different question, and the one people quote is usually the least informative.
  5. The balance sheetWhat the company owns, what it owes, and what is left for owners — on one specific day, which is usually the day it was most able to arrange. Reading it well means asking how it got that way.
  6. The cash flow statementThe one that is hardest to arrange, because cash either arrived or it did not. Read it before the profit figure and most accounting disappointments announce themselves a year or two early.
  7. The notes and the auditorThe statements are the headline and the notes are the article. The auditor's opinion comes in four flavours, and a listed company has to file a standard statement saying what the qualifications cost — which nobody reads.

Intermediate

  1. MarginsWhat fraction of each rupee of revenue survives to each stage. Margins say more about a business's position than almost any other number, and their direction over years says more than their level in one.
  2. Return on capitalHow much profit the business produces for each rupee tied up in it. This is the number that separates a good business from a large one, and it is the closest thing this subject has to a single verdict.
  3. The DuPont decompositionReturn on equity splits into three things: how much each sale earns, how hard the assets work, and how much debt is underneath. Two companies with the same ROE can be opposite businesses, and this is what shows it.
  4. Working capitalThe money tied up between paying suppliers and collecting from customers. It is where a growing company's cash disappears, and where a deteriorating one shows it first — usually a year before the profit figure admits anything.
  5. Debt and solvencyDebt is judged against the cash flow that services it, not against the assets that back it. The question is never how much is owed — it is whether the payments can be made, and what happens if they cannot.
  6. GrowthRevenue can rise for half a dozen reasons and only some of them are worth paying for. The useful questions are where it came from, what it cost, and whether the returns on the money spent justify having spent it.
  7. Quality of earningsTwo companies can report the same profit and mean quite different things by it. Quality is about how much of the reported figure is cash the business actually produced, and how much rests on judgements that could have gone another way.
  8. The things in the footnotesRelated party transactions, contingent liabilities, pledged shares and off-balance-sheet obligations. All disclosed by rule, all easy to find, and collectively the most reliable source of unpleasant surprises in the accounts.

Advanced

  1. Valuation, the ideaA business is worth the cash it will produce for its owners, discounted for the fact that money later is worth less than money now. Every valuation method is an approximation of that one sentence, including the lazy ones.
  2. P/E and its trapsThe most quoted number in equities, computed from a denominator that can be chosen, depressed or imaginary. A low P/E is not cheap and a high one is not expensive — both are questions rather than answers.
  3. EV/EBITDAPrices the whole business rather than the shareholders' slice, which makes it the right multiple for comparing companies with different amounts of debt. Its weakness is the one letter it ignores: depreciation.
  4. Price to bookPrice against the accounting value of what shareholders own. Nearly useless for a company whose value is people and brands, and the right tool for banks and for cyclicals whose earnings cannot be trusted this year.
  5. Discounted cash flowThe method that states its assumptions instead of hiding them. Build it once and you learn how little of a company's value sits in the years you can actually forecast — which is the most useful lesson it teaches.
  6. Reverse DCFInstead of forecasting what a company will do and deriving a value, take today's price and solve for what it already assumes. It removes your own optimism from the calculation and asks a question you can actually answer.
  7. Putting it togetherTwenty-one chapters in the order you would actually use them, as a sequence that answers four questions — what the business is, how good it is, what it is worth, and what the price assumes.